Problem 17 - Accounting

Question

Isner Company wrote off the following accounts receivable as uncollectible for the first year of its operations ending December 31, 2010: \begin{tabular}{lr} Customer & Amount \\ \hline L. Hearn & \(\$ 10,000\) \\ Carrie Murray & 9,500 \\ Kelly Salkin & 13,100 \\ Shana Wagnon & 2,400 \\ \(\quad\) Total & \(\$ 35,000\) \\ \hline \end{tabular} a. Journalize the write-offs for 2010 under the direct write-off method. b. Journalize the write-offs for 2010 under the allowance method. Also, journalize the adjusting entry for uncollectible accounts. The company recorded \(\$ 2,400,000\) of credit sales during 2010. Based on past history and industry averages, \(1 \frac{3}{4} \%\) of credit sales are expected to be uncollectible. c. How much higher (lower) would Isner Company's 2010 net income have been under the direct write-off method than under the allowance method?

Step-by-Step Solution

Answer

Net income under the direct write-off method is $7,000 higher than under the allowance method.

Step 1: Direct Write-Off Method Journal Entries

Under the direct write-off method, we record actual accounts deemed uncollectible directly into Bad Debts Expense. Thus, for each customer, create a journal entry to write off the uncollectible amount. For L. Hearn: - Debit Bad Debt Expense \(\\(10,000\) - Credit Accounts Receivable - L. Hearn \(\\)10,000\)For Carrie Murray: - Debit Bad Debt Expense \(\\(9,500\) - Credit Accounts Receivable - Carrie Murray \(\\)9,500\)For Kelly Salkin: - Debit Bad Debt Expense \(\\(13,100\) - Credit Accounts Receivable - Kelly Salkin \(\\)13,100\)For Shana Wagnon: - Debit Bad Debt Expense \(\\(2,400\) - Credit Accounts Receivable - Shana Wagnon \(\\)2,400\)

Step 2: Allowance Method Journal Entries

Under the allowance method, we estimate future uncollectibles using historical data and industry averages and record these in the Allowance for Doubtful Accounts. First, make an entry for the specific accounts that are uncollectible this year:- Debit Allowance for Doubtful Accounts \(\\(35,000\) - Credit Accounts Receivable \(\\)35,000\)Next, make the adjusting entry to update Allowance for Doubtful Accounts to reflect estimated uncollectibles for the year:- Calculate the estimated uncollectible: \(1.75\% \times \\(2,400,000 = \\)42,000\)- Debit Bad Debt Expense \(\\(42,000\) - Credit Allowance for Doubtful Accounts \(\\)42,000\)

Step 3: Net Income Comparison

The direct write-off method results in a total bad debt expense of \(\\(35,000\), while under the allowance method, the expense is estimated at \(\\)42,000\). To find the difference in net income:- Subtract bad debt expense under the allowance method from the direct write-off: \(\\(42,000 - \\)35,000 = \\(7,000\)Thus, the net income would have been \(\\)7,000\) higher under the direct write-off method than under the allowance method.

Key Concepts

Direct Write-Off Method

The Direct Write-Off Method is a simple technique used by companies to account for uncollectible accounts receivable. Under this method, once a company determines that a debt will not be collected, it directly writes off the uncollectible amount. This occurs when the debt is judged to be non-recoverable, often because the debtor has gone bankrupt or is otherwise unwilling or unable to pay.
The journal entries are straightforward. Each write-off requires the company to:

• Debit Bad Debts Expense for the amount of the uncollectible account.
• Credit Accounts Receivable for the same amount, reducing the accounts receivable balance.

The simplicity of this method is an advantage; however, it does not comply with the matching principle in accounting, as expenses might be recorded in a different period than the revenues they are related to.

Allowance Method

Unlike the Direct Write-Off Method, the Allowance Method anticipates future uncollectible accounts and estimates these losses in advance. This aligns with the accrual accounting principles, where expenses are matched with the revenues they help to generate.
To implement the Allowance Method, consider the following steps:

• Estimate the amount of uncollectible accounts using historical data or industry averages. For instance, if a company forecasts that 1.75% of its credit sales will be uncollectible, this estimation forms the basis for journal entries.
• Create a journal entry to record this estimated amount by debiting Bad Debts Expense and crediting Allowance for Doubtful Accounts, a contra-asset account that reduces the total accounts receivable on the balance sheet.
• When specific debts are deemed uncollectible, the allowance is utilized by debiting Allowance for Doubtful Accounts and crediting Accounts Receivable for the specific amounts.

This method provides a more realistic view of a company's financial status by recognizing bad debt expenses in the same accounting period as the credit sales, ensuring adherence to generally accepted accounting principles (GAAP).

Bad Debts Expense

Bad Debts Expense is an account used to represent the estimated losses related to accounts receivable that are not expected to be collected. It is a crucial component of both the Direct Write-Off and Allowance Methods, though applied differently in each case.
In the Direct Write-Off Method, Bad Debts Expense is only recorded at the time a specific account is written off. This can lead to fluctuations in reported expenses and can impact financial statements from period to period.
Under the Allowance Method, Bad Debts Expense is recorded based on an estimate, aiming to match the expense with the related revenue period. By anticipating future losses, companies can ensure that their income statements reflect a more consistent and realistic picture of financial health.
Maintaining accurate records of Bad Debts Expense helps businesses to better manage their cash flow and financial planning by accounting for potential losses due to unpaid debts.

Net Income Comparison

The comparison between these two methods primarily impacts the net income reported in financial statements. In our specific case with Isner Company, who reported bad debts of $35,000 under the Direct Write-Off Method, the financial statements reflected this loss directly.
However, under the Allowance Method, the estimated bad debts expense was higher, at $42,000, based on a percentage of total credit sales. This results in a reduced net income compared to the direct write-off scenario.
Specifically, in 2010, the difference in net income due to these methods was $7,000. Under the Direct Write-Off Method, Isner Company's net income would have been $7,000 higher compared to the Allowance Method. While the Direct Write-Off Method may show higher net income temporarily, it can distort the true economic activities of the company by not matching expenses accurately with revenues.